When 0% Financing Loans are Not Worth It

On December 16, 2012

Cars, furniture, dentistry, everyone seems to offer 0% financing. It’s not just your everyday low price. The law of arbitrage, the central rule by which all market and investing options are judged, is screaming behind this saying “Here I am! Come take me!”

The law of arbitrage is simple. If you can borrow money at one price and invest it at a higher one, you will be able to sell the asset, pay off the loan, and pocket the difference. In the sense of financing it would be buy something and finance it for nothing, then put it in a bank account and receive free interest.

If only it were that easy.

First, foremost, and without any question, you need to look at discounts for paying up front. These are everywhere. Car dealers, however, are particularly famous for it. “Get $1000 cash back or 0% financing”.

How much is that cash back really worth? Let’s assume it’s a $20,000 car. $1000/20000 is a 5% discount. You must forego that if you want to get the 0% financing. A lost rate bonus of 5% is actually the price of an interest-free loan. Obviously if you were going to pay cash for this car you wouldn’t dream of taking the 0% for the bonus unless you had some very nice investments to make.

Today the APL Federal Credit Union said that it will make a new or used car loan at the rate of 2.39%. Here it can be tricky, and it’s worth sitting down with a loan interest calculator to check it. If you took a loan of $19,000 and paid it over 5 years, you’d pay $1,176 in interest. That’s $176 more than if you took the 0% financing without the cash bonus. So if you weren’t going to make any prepayments on a 5 year loan, the 0% is worth it.

Yet if you are going to pay it off in 4 years, increasing your payment by less than $50 a month, you’d pay only $941 in interest. If the payment made you nervous, you could simply take the 5 year loan and increase the payments when your budget left you with extra cash. Here the 0% costs more than it is worth.

Another thing to consider is the trade-in of the car. Many people don’t keep their cars until the loans are paid off, but trade them in and use the value to pay off the loan. Obviously you aren’t going to pay as much in interest if you don’t see the loan to completion, so the 0% isn’t helpful. Furthermore, if you take the 0% loan, you will actually owe more on the car when you trade it in and will have less value to apply to the next one.

There are some bona-fide “same as cash” deals, with no bonus for paying early. These usually have a set duration, and some of them will apply all of the interest that they waived if you don’t make the full payments by the deadline. Read the fine print before taking the deal.